Court of Appeals Gives Guidance on How to Implement Tiered Pricing

April 21, 2015

Yesterday, the Fourth District Court of Appeals issued its long-awaited decision in Capistrano Taxpayers Association, Inc. v. City of San Juan Capistrano (4th DCA No. G048969), which considered a challenge under Proposition 218 to the City’s tiered rate structure. Although many news reports have seen this decision as the end of “conservation pricing,” we believe that this decision validates the use of conservation pricing and smart planning for new water projects, as long as the public agency “shows its work” in apportioning the costs of those projects among ratepayers.

The City’s Tiered Rate Structure and the Trial Court’s Ruling

In setting its new water rate structure, the City followed what is known as the “M-1” manual, which is used by many public water agencies throughout the western United States. It first ascertained its total costs and the components of those costs, then identified classes of customers according to type, such as residential customers, agricultural customers, and so on. For each class of customer, the City calculated four water “budgets” ranging from “low” to “very excessive.”  The four budgets were used to set four price tiers for each class. For residential customers, the lower tier was intended to apply to relatively low levels of water use for indoor purposes, while the highest tier would apply to uses the City considered excessive. The City allocated its total costs between the tiers such that, as a whole, the pricing system was revenue neutral. However, the City did not calculate the actual costs of providing water at the level of use represented by each tier, and at oral argument the City acknowledged that it used the higher revenues from the top tiers to subsidize below-cost rates for the lowest tier. In addition, the rate structure included capital charges related to the provision of recycled water, and specifically the construction of a recycled water plant.

The superior court made two key findings. First, it found that the tiered rates did not comply with Proposition 218’s requirement that charges reflect “the cost of service attributable to” a parcel because there was a lack of support for the discrepancy between the rates assigned to the price tiers. Second, it found that the City’s inclusion of charges for recycled water violated the requirement that the services for which a Proposition 218 charge is imposed be “immediately available” to property owners, because the City’s residential customers did not and for the most part would not use recycled water.

The Court of Appeals’ Decision

Agencies May Allocate the Costs of Obtaining or Developing New Water Supplies to Existing Customers

Regarding the recycled water charge, the Court of Appeal concluded that the trial court had erred in assuming that the recycled water service was fundamentally different than the City’s regular water service.  The Court held that generally, the provision of traditional potable water and the provision of recycled water are not separate services:  instead, since providing recycled to some customers water “frees up” potable water for other customers, providing each kind of water is part of the same service.  As stated by the Court, “[w]ater service is already ‘immediately available’ to all customers, and continued water service is assured by” capital improvements such as the construction of water recycling facilities. Thus, a water provider can properly pass on the costs of developing new water sources (such as recycled water) to existing customers if those customers’ “marginal or incremental extra usage” contributed to the need to develop those sources. However, the Court also found that there was insufficient evidence to allow it to determine whether the recycled water charge had been improperly applied to users whose levels of water consumption were so low that they could not be said to be responsible for the need for the City to use recycled water as a source, and remanded the matter to the trial court for further findings on that point.

The Court’s conclusion regarding the recycled water issue is an important one, as it makes clear that when agencies seek to develop new water supplies in connection with existing water serviced (whether from recycled water or some other source), Proposition 218 does not prohibit them from allocating a portion of the costs of doing so to existing customers. Instead, agencies may properly charge existing customers for the costs of developing new water sources that will become part of the existing water service, unless a customer’s water use is so low that the need for additional water supplies cannot be fairly attributed to that customer. This portion of the ruling will provide greater certainty to water agencies that must determine how to finance the costs of necessary capital improvements or new facilities.

In Setting New Rates, Agencies Must Be Able to Show That the Rate Tiers Reflect the Costs of Service Attributable to the Parcels in Question

The Court of Appeal upheld the trial court’s conclusion that the City improperly failed to calculate the cost of actually providing water at the various tier levels, and so could not show that its water charges did not exceed the costs of service attributable to various parcels. The Court found that to comply with the mandate that charges not exceed the costs of service, a water provider must do more than simply balance its costs and total revenues – it must also correlate tiered prices with the actual costs of providing water service at those tiered levels. As the City had not even attempted to make this showing, the trial court was correct to find that the rate structure violated Proposition 218.

It is important to note that the Court was clear to state that tiered water rate structures and Proposition 218 are “thoroughly compatible ‘so long as’” the rates reasonably reflect the cost of service attributable to each parcel. A key flaw in the City’s argument was that the City rejected the notion that there must be a correlation between tiered water prices and the costs of providing service at the various price levels, and instead argued that Proposition 218 must be balanced against article X, section 2 of the California Constitution, which provides that waste and unreasonable use of water must be avoided and that the conservation of the state’s waters must be exercised with a view to reasonable and beneficial uses.

In rejecting this argument, the Court of Appeal noted that nothing in article X, section 2 requires water rates to exceed the true cost of supplying water, and so could not be said to trump the provisions of Proposition 218. Instead, the Court found that article X, section 2 and the provisions of Proposition 218 are compatible, because it is possible for an agency to impose tiered pricing that is intended to serve the goals of article X, section 2 while still complying with Proposition 218. In reaching this conclusion, the Court noted that in times of drought “providing water can become very pricey indeed,” and that there was nothing wrong with a water provider passing on the higher costs of water during droughts to those who use more water – as long as the price reflects the true costs of water, rather than lines drawn based on water budgets. In other words, the Court recognized that article X, section 2 and Proposition 218 work together to promote increased water supplies (and, presumably, efficient use of water).

An Agency Cannot Avoid Compliance With Proposition 218’s Requirements By Simply Deeming a Rate a “Penalty”

Finally, the Court of Appeal also addressed the City’s argument that the higher rates could be justified as penalties that do not fall under Proposition 218 at all. The Court found that the City’s theory was inconsistent with the Constitution because it would open up too large a loophole in the proportionality requirement. In this regard, San Juan Capistrano may at first blush appear to diverge from the recent case of Great Oaks Water Company v. Santa Clara Valley Water District, which acknowledged the possibility that Proposition 218 might not be intended to foreclose the structuring of fees in such a way as to regulate, through market forces, the consumption of a scarce resource like water. However, the two cases can (and should) be read compatibly: The Great Oaks court did address the question of using rates to regulate water consumption, and did not foreclose the prospect that such a rate structure would be permissible. However, it rejected the claim before it that the rate structure before it was intended to regulate water consumption via market forces, because there was no evidence that the rate structure was designed to accomplish that result. The San Juan Capistrano court did not address the question regarding whether it was proper to use tiered rates to bring market forces to bear on water consumption, but focused on the City’s argument that if a high rate can be justified as a “penalty” then it does not have to comply with Proposition 218 at all. It thus appears that a clear distinction can be drawn between an agency’s efforts to discourage consumption of water via a tiered price structure and an agency’s efforts to use a tiered pricing to punish certain uses of water.

Conclusion

In summary, there are four key points to take from San Juan Capistrano. First, a water provider can, consistent with Proposition 218, impose charges for the development of new water supplies upon existing customers. Second, in setting rate structures, agencies must be careful to “show their work” and be able to explain to a court the basis for tiered pricing, much like an agency engaged in CEQA review must be able to explain the path it traveled from the raw data to its CEQA conclusions. Third, tiered rates can be used to further the goals of article X, section 2 of the California Constitution without running afoul of Proposition 218, as long as the agency in question makes the necessary showing. Fourth, it is not entirely clear from San Juan Capistrano what standard courts should apply when reviewing the calculations that support an agency’s tiered price structure. The Court found that the City had to do more than merely balance its total costs with its total revenues, but it also rejected the notion that the City was required to calculate rates on a strict parcel-by-parcel basis, for example, one rate for one residence and another rate for another residence. Precisely what an agency must show to support a tiered rate structure thus lies somewhere between those two extremes. The San Juan Capistrano court did provide some additional guidance by stating that tiers “must be based on usage, not budgets,” and by positing that if the City had determined the costs of given usage levels given the costs of the City acquiring water to meet those levels, its rate tiers could have passed muster. We believe that if a public agency determines the costs of usage levels (e.g., the low, medium, high and excessive tiers used by the City) and links its rates to those costs, a reviewing court should give substantial deference to that determination. It is only with such deference that the courts can play their proper role in enforcing the requirements of Proposition 218 and – at the same time – allowing water agencies to implement the mandate of article X, section 2 of the California Constitution.